Coyote Blog

A few thoughts in follow-up to this post on GME and short-selling

1.  The general celebratory air around the story of Gamestop (GME) is driven, I think, in large part because no one other than a few hedge funds who had naked unhedged short positions in GME.  But recognize we are still only in the middle of this story.    This is like reporting on the Titanic after the first lifeboats were away successfully but before the first drownings.  There is no WAY that Gamestop is going to remain over $300, or even over $100.  Gamestop has almost nothing you would want to own -- bricks and mortar retail locations that sell digital product -- and yet its valuation is higher than even the hottest of retailers.  It is something like 6-8x the valuation on a price-to-revenue basis (so such thing as a PE as it loses a ton of money) of other similarly threatened retailers like Best Buy.  Its valuation is even well above players like Home Depot, which unlike Gamestop a) makes a profit b) sells a bunch of stuff that can't be sold easily online and c) is growing rather than shrinking.  Within 30 days or less GME will be back under $40 is my guess.
2. This stock windfall is thus essentially a pyramid, no different than other attempts to corner a limited market, and will eventually fall to Earth.  Those in and out early will win -- and those are the folks winning praise and love across the media.  Those out late will lose out.  Had I been in the stock, I would never ever have stayed in the stock past the market close on Friday
3. Every professional investor and institution that does not have a lockup or some portfolio rule that keeps them in Gamestop is out.  I would fire any professional that did not take the opportunity to unload this bankrupt dog worth $20 or less at a price over $300.  So all that is left are redditors who are keeping the stock afloat by turning over more than the entire stock float every day, thus elevating it by some investor version of Boyles law.
4. If the folks in the stock now are like the other redditors who got in early, they are very leveraged.  This leverage allowed folks to claim huge gains with small investments, but in turn will leave small investors at the end with huge losses.

My prediction is that 30 days from now, we will look back on this story very differently.  Perhaps I am just a member of the HBS-educated elite and can't see past my traditional views on investing, but I STILL don't think that highly leveraged momentum investments on near-bankrupt stocks in collusion with other investors of whom one knows nothing is a good approach for the typical small investor.

Update:  Aaaaaand it only took 2 days.  Do we still feel like this is a heroically great story for the everyman?  We got to enjoy regular dudes making a fortune on the way up with highly-leveraged investments in a pyramid / pump-and-dump scheme.  Do we get to see stories of people holding leveraged positions at $400?

A group of day traders who congregate and coordinate on various online platforms made a name for themselves over the past week running up the stock price of struggling Gamestop (GME), in the process laying some epic losses on a few high-profile short sellers.  As might be expected in the current political age, the entire body of both economic thought and 90 years of stock market regulatory theory have been thrown out in the ensuing brouhaha in favor of an in-group / out-group narrative, ie underdog economic losers against entrenched billionaire elite insiders.  As Glenn Greenwald describes it:

Although it may be more complex than this once all the facts are all known, this is being treated — by those excited by it and those aghast — as a type of populist uprising, a David v. Goliath tale in which ordinary people united to brilliantly beat Wall Street at its own game, thereby transferring plutocratic wealth back to the public. Oligarchs and their media spokespeople spent all day on CNBC and other pro-Wall-Street outlets expressing outrage and demanding government intervention to protect them from what they regard as this grave injustice.

Given this narrative is already fixed firmly in place, it is almost impossible to comment thoughtfully or discuss it with anyone.  On the one hand these traders aren't doing anything that Carl Icahn did not do to Bill Ackman at Herbalife, and I can' see any reason why their communication channels or ability to trade certain stocks should be shut down.  On the other hand, this sort of crazy volatility is not good for confidence in markets.  Remember that driving GME to unrealistic levels produces everyman millionaires of the folks who were first in and driving the train, but there is no way the stock price levels are sustainable and just as surely a lot of other regular folks, just like the last ones into a pyramid scheme, are going to lose a lot of money.  I will say that this whole narrative of the stock market suddenly becoming a path for the downtrodden common man to make a fortune has a very 1928 vibe to it.

By the way, to understand what is going on, basically these guys attempted and succeeded for a time in cornering the market in GME stock, really no different from any attempt to corner a market in a commodity and drive the price up.  In this case, the wallstreetbets folks are seeking out companies with a very small "float" -- companies that may have a lot of stock outstanding but only a small amount trades actively because of insider and founder shares and shares that have been borrowed and shorted.  Combining a small float with a large short interest can lead to a sharp rise in prices that is accelerated as short-sellers are forced to cover as their losses mount.  As with any such attempt,  whether by the Hunts in silver or these guys in GME, eventually the pyramid can't be sustained and the price collapses again.  When presented this way, it is amazing to me that socialists like Greenwald are cheering on this kind of behavior.  It is a seeming contradiction but I think I know the answer:  short-selling.

I may be overreading this, but a LOT of the support for the WallSteetbets bros seems to be due to the fact that they took down a bunch of prominent short-sellers, who are considered by the public to be barely one step above child molesters on the ethics scale.  Glenn Greenwald, for example, wrote that this is a story about heterodox groups that "unite in opposition to hedge fund short sellers, who contribute nothing of value."  Had these folks united instead to hammer a popular stock like Apple or Tesla down, I am pretty sure the receptions would have been VERY different, even though the basic narrative would be identical.

So is short-selling really a plague that contributes nothing of value?  I have argued many times that it is very valuable.  But let me try again.

Markets don't have a purpose per se beyond the facilitation of individual goals.  Individuals come together in mutually beneficial trades that create value for both parties.  This is ultimately true of capital markets like any other market -- some people want a place where their savings can earn more than in a checking account, and other parties need these funds to support their business operations and growth.  Individual investors shift their money around as the perceive better risk/reward opportunities for their investment.  This is what capital markets were created for, not to serve some higher macro-economic purpose.

But they do serve a higher purpose, and the reason is at the heart of the magic of capitalism.  Because we know that well-functioning markets with clearly understood and consistent rules populated by folks just trying to look after themselves are critical to a productive, growing economy.  At the heart of this magic is the market's role in the efficient allocation of capital to the most productive enterprises.  Again, this all occurs bottom up.   If there are two widget manufacturers making identical products, but one produces them twice as expensively as the other, we are all going to be better off long-term if the more efficient company thrives.  This tends to happen naturally in the capital markets -- more productive companies get more capital, less productive companies do not.

One of the worst things that can happen in an economy is to have scarce capital misallocated, by some market inefficiency, to unproductive or less productive purposes.   And herein lies the societal benefit of short-sellers. I will not say it is their "purpose", because their purpose is to make money (though a lot of short-sellers are driven by righteous ethical indignation about fraud and ironically often have a higher ethical component to their investment choices than do the longs).  But the larger benefit of the actions of short-sellers is to shift capital away from unproductive companies, because every dollar in capital poured into these companies is a dollar that is not invested in something that creates more wealth and benefits for the world.

Something folks may not know but investors are well aware of it -- there is a large raft of "zombie" corporations out there that shamble along unproductively but still consume huge amounts of scarce capital.   Some have government support (eg Boeing).  Others continue to survive for years eating the seed corn of their past reputation, market position, and infrastructure.  Almost all of them are being supported by the Fed's huge money-printing program that tries to keep both the DJIA and the Fortune 500 afloat.

They were once America’s corporate titans. Beloved household names. Case studies in success.

But now, they’re increasingly looking like something else -- zombies. And their numbers are swelling.

From Boeing Co., Carnival Corp. and Delta Air Lines Inc. to Exxon Mobil Corp. and Macy’s Inc., many of the nation’s most iconic companies aren’t earning enough to cover their interest expenses (a key criterion, as most market experts define it, for zombie status).

More than 200 corporations have joined the ranks of so-called zombie firms since the onset of the pandemic, according to a Bloomberg analysis of financial data from 3,000 of the country’s largest publicly-traded companies. In fact, zombies now account for nearly a quarter of those firms. Even more stark, they’ve added almost $1 trillion of debt to their balance sheets in the span, bringing total obligations to $1.98 trillion. That’s more than the roughly $1.58 trillion zombie companies owed at the peak of the financial crisis.

The consequences for America’s economic recovery are profound. The Federal Reserve’s effort to stave off a rash of bankruptcies by purchasing corporate bonds might very well have prevented another depression. But in helping hundreds of ailing companies gain virtually unfettered access to credit markets, policy makers may inadvertently be directing the flow of capital to unproductive firms, depressing employment and growth for years to come, according to economists.

Even if only half of that is misallocated, that's a trillion dollars of investment capital that could have been better deployed elsewhere.  It's a dead loss to the economy.  Short-sellers are our gladiators trying to bring down some of these zombies.

So let's consider Gamestop (GME).   GME is mainly a group of bricks and mortar stores selling digital content.  Huh?  Stores that sell freaking refrigerators have been hammered by online sales, do we really think that GME makes any sense any more?  But by driving up the price 20x, these supposedly heroic momentum investors are sending a capital market signal that this is the place, in physical stores selling digital content, that the world should put its scarce capital -- not in new bioscience investments, not in electric vehicles, not in new forms of energy technology -- but right here in physical locations next to a Safeway to allow people to buy stuff they could download less expensively in 5 minutes in their own home.  In this context, the GME shorts were freaking heroic.

Updates:

1. To be clear, because I know how these "with us or against us" issues go, just because I am defending the action of short-selling does not mean that I support restrictions on these day traders.  I think Robinhood is making a mistake in restricting trading of its members in GME and I don't like talk of restricting certain Reddit investment forums any more than I support any other proposed restrictions on online speech.  I do think the WallStreetBets folks are being irresponsible to ordinary investors, and high-profile stories of big leveraged wins by some blue collar day traders in momentum strategies is going to result in some huge losses for other small traders getting caught holding the bag at the end of the run.
2. Essentially, the Tesla run up has just been a slow motion duplicate of the GME runnup, with day-traders who ignore any value metric making gains due to the small float, potentially with added manipulation in the call option market.
3. GME is currently down almost $100 per share or 28% from yesterday's close, and down $200 from today's intra-day high.  I wonder if Greenwald wants to celebrate all those underdog investors that bought in <4 hours ago at $200 higher.

Update 2: I do want to thank some group of momentum knuckleheads for driving up the price of mall owner Macerich yesterday.  I sold right at the intraday high (which was 2x the price just 2 days before) and got out whole from a crappy loss position when I thought I was going to have to wait that one out for years.

I need some alert service that says the momentum bros are playing games with such and such stock, get out now while the bagholders are buying.

Update 3:  At one point today GME was trading at 5.5x 2019 revenues -- as a bricks and mortar retailer.  Best Buy, for reference, is trading today at 0.68x 2019 revenues.  And for all its problems, if I had to choose, I would rather own Best Buy than Gamestop.

Real estate investment trusts (REIT's) have had their stock values pounded in the last six months, and is it any wonder?  Many have tenants who aren't even allowed to open, who are slowly (or quickly) going bankrupt and not paying their rent bills.  Industrial REITs are doing OK (particularly those that specialize in data centers and e-commerce warehouses), but will shopping malls ever come back under the Amazon/COVID 1-2 punch?  Will office real estate survive now that many companies are getting more comfortable with work at home?

I picked up a few REIT stocks at the bottom I thought had been pounded too far, and was lucky to have Warren Buffet jump into one of them after me ($STOR).  Which got me to looking at office REITs.  We have seen stories like the ones of REI giving up their entire headquarters for work at home.  Many people reading this may still be working at home.  Large companies may continue to pay their rent until their leases run out, but will anyone be renewing those leases in the future?

At first, my answer was that the commercial office real estate business was going to suck for many years, and I have not totally changed my mind on that (relatively obvious) conclusion.  But then I started to think about a few things that have happened to me in the last few weeks

• My banker, who was working at home, was unable to complete a couple of tasks I needed from him because Bank of America would not allow him to handle certain confidential information in his home or via his home computer
• I rented an extra office for a new HR director I have added to my own company -- not because she really wants an office or uses it much -- but because we had to have a secure locked location to store confidential employee files
• Working with my attorney on a deal has been inefficient because he does not have access to files and certain resources at the law firm

This raises a question -- is some amount of commercial real estate necessary just for security concerns (banking, financial data, employee data, HIPAA, legal correspondence)?  Perhaps in the near term.  But if we really get more comfortable with working remotely, then the ultimate solution is not to keep expensive office space for file cabinets and secure networks but to create document and data management models that secure data even when everyone is working remotely.  There are a lot of pieces to this, but some of them include

• Hardware/Software solutions to secure notoriously poorly secured home networks and computers
• More commitment to HRIS and on-boarding systems to move all employee paperwork off paper and into the cloud
• A return to some of the "paperless office" services that really did not catch on.  For example, services that receive all company mail and scan it and then distribute it digitally.
• For old dead tree documents, which I guarantee will still exist, more use of 3rd party / remote file management and storage solutions

I am quite convinced there are going to be some new businesses here -- and so far we have zoom and not much else.  If I was in technology, I would be thinking if I had the technology or the position to solve problems in this space.

One company that intrigues me is Iron Mountain ($IRM).  They have said nothing that I have seen in their marketing about post-COVID opportunities, but their business model (a combination of paper and digital document management and storage solutions) seems a good fit.  I think they are sitting in a very interesting spot to benefit from the post-COVID work environment, and I have bought a block for my portfolio (which is not that painful to hold on the come because it also pays an 8.5% dividend).

PS-  I am not an investment advisor and just have fun casually thinking out loud about investments and markets, from time to time.  The vast majority of my money is invested in my own business, which, through absolutely no foresight on my part, happens to be in one of the few retail segments and virtually the only hospitality segment to see record revenues this year (camping).  I am trying to think about long positions because, like someone who only recently gave up smoking, I am trying my absolute best to give up on shorting stocks -- it is just too painful in this nutty market *cough* Tesla *cough*.   With my skepticism I bring to most things, shorting is a natural fit for me but there is only so much pain I am willing to endure to fight an overly-active Fed and an overly-dormant SEC (this article plus my personal experience caused me to capitulate).  I do still have a few shorts on the books, including $tsla of course for tradition sake, but these now amount to what are essentially bar bets.

Note the new ETF products:

GraniteShares has listed 18 ETPs offering three-times leveraged and inverse exposures to popular US-listed stocks.

The 18 leveraged and inverse ETPs are listed on the London Stock Exchange (LSE) with a total expense ratio of 0.99%.

The stocks covered include most of the momentum Robinhood favorites, including Tesla, Uber, and Apple.  Nothing says "top of the market" like investing in the "GraniteShares 3x Long Tesla Daily ETP (3LTS)" whose underlying stock has a PE of like 1200 or even better in the "GraniteShares 3x Long Uber Daily ETP (3LUB)" whose underlying stock has never even come close to being able to calculate a PE.

This was my favorite line, "The ETPs enable sophisticated investors..."  LOL, I am pretty sure that sophisticated investors are able to much more efficiently leverage their trades if they want this much leverage (in any market, but particularly a volatile one, the math of the daily resets means not only a lot of fees, but also a steady value leakage from the fund -- see postscript).

The game is given away in the next line which says, "The range of ETPs is listed at $5.00 per share while most of the underlying stocks trade at prices in excess of $200".  Right, because sophisticated investors can't come up with $200 for a single share.   This product is obviously aimed, entirely inappropriately, at new Robinhood style NOOBS day-trading with their unemployment check and who grew up in an era when stocks only go up (and whose value is, like Bitcoin, untethered to any fundamental).

This is sleazy as hell -- avoid it at all costs.

Postscript:  Here is an example of the result of the leakage math that just gets worse in a volatile market like we have had this year.  Consider two existing S&P500 3x leveraged funds, SPXS is triple short and SPXL is triple long.  The S&P is up 8% for the year, so the average investor would think, "so, SPXS is down 24% and SPXL is up 24%"?  But that is not right, because of the daily recalculation in a volatile market.  We will ignore the math (sometime I might post a spreadsheet) but the result is this:  With the S&P500 up 8% YTD, the SPXS is down a whopping 60% and the SPXL is DOWN (not up) but down almost 9% -- you can see this right on their web site.  You would have been better off in either case just to buy or short SPXX with leverage.   You might have even been better with options -- making leveraged bets on momentum stocks generally means one expects volatility, and at least options increase rather than decrease in value with volatility.  You have to deal with expiration and theta in options, but as we have seen these leveraged funds have their own theta-like behavior over time.

Warning:  I am not, not, not an expert nor a licensed investment advisor or any other sort of advisor.  But take my word for it -- don't buy these.

It is not October of 1929 yet, but we are getting close in the stock market.  A few parallels

• A 10+ year bull market where many retail participants can't even remember a bear market
• New low cost brokerage models (in the modern case, zero-commission trading at Robin Hood and emulated by most major brokerages) attracting new inexperienced investors and increasing the trading frequency in retail
• A government that is completely clueless to its policies that artificially inflate asset prices

We see stocks today that are traded absolutely untethered to their fundamentals as if they were bitcoin rather than ownership interests in productive companies (e.g. Virgin Galactic, Plug power, Apple, Tesla, etc).  Virgin Galactic doesn't even have the prospect of selling its first product and has run up to a $6 billion valuation.  Tesla has an enterprise value close to the largest car company in the world (Volkswagon) despite 1/20 the car sales, no profitability, and stalled revenue growth.  The market in general goes way up on good news and then goes up on bad news.

Be cautious everyone.

I will refer you to my post last December on how much of society seems to hate short-sellers, and on some of the virtues of short selling.

For this post I just wanted to make a more narrow point -- one reason that unicorns (private startups with valuations north of $1 billion) like WeWork and Uber and Peloton had their valuations get so out of whack is because there is no way to short stocks in the private equity world.

Companies like Lyft and Uber and WeWork have seen private funding rounds at ever-increasing valuations.  These are done outside the accountability of the broader market and untethered to any sort of normal valuation metrics like earnings or even revenues.

Lots and lots of investors, perhaps the vast majority of them, believed that the last private round that valued WeWork at $45 billion was insane.  Many folks, including myself, would have gladly shorted the stock at this price had we been able.  Heck, many of us would have shorted back at $10 and $20 billion valuations for the company.  Because there is no short selling in this private equity world, unicorn valuations are +based on information from a very limited number of the most optimistic company supporters.  And because of this faulty price discovery, billions of capital that could be doing something more productive have been wasted in many of these companies, poured into business models that don't work or, worse, the tequila and drug fueled Gulfstream flights of the founders.

As I wrote over a decade ago, short selling broadens the group of people who can "vote" on a company's value

At the start of the bubble, a particular asset (be it an equity or a commodity like oil) is owned by a mix of people who have different expectations about future price movements.  For whatever reasons, in a bubble, a subset of the market develops rapidly rising expectations about the value of the asset.  They start buying the asset, and the price starts rising.  As the price rises, and these bulls buy in, folks who owned the asset previously and are less bullish about the future will sell to the new buyers.  The very fact of the rising price of the asset from this buying reinforces the bulls' feeling that the sky is the limit for prices, and bulls buy in even more.

Let's fast forward to a point where the price has risen to some stratospheric levels vs. the previous pricing as well as historical norms or ratios.  The ownership base for the asset is now disproportionately made up of those sky-is-the-limit bulls, while everyone who thought these guys were overly optimistic and a bit wonky have sold out. 99.9% of the world now thinks the asset is grossly overvalued.  But how does it come to earth?  After all, the only way the price can drop is if some owners sell, and all the owners are super-bulls who are unlikely to do so.  As a result, the bubble might continue and grow long after most of the world has seen the insanity of it.

Thus, we have short-selling.  Short-selling allows the other 99.9% who are not owners to sell part of the asset anyway, casting their financial vote for the value of the company.  Short-selling shortens bubbles, hastens the reckoning, and in the process generally reduces the wreckage on the back end.

I am not advocating some goofy plan to bring short-selling to private equity.  What I am saying is that prices set in markets with a robust ability to sell short are going to be much more trustworthy than prices set where short-selling is not an option.

Today after the market closed was Tesla's analyst conference call to review  fourth quarter earnings.  TL:DR It was as weird as ever, maybe weirder.  Even before the call, Elon Musk said that the numbers released today would be un-audited, and the call ended by saying -- in a sort of "oh by the way" over the shoulder parting shot -- that their CFO was leaving and being replaced by a 36-year-old with only Tesla experience and no prior CFO role (not unlike the random young dude that the Arizona Cardinals just hired as their coach, but that is another story).  Neither Musk statement was a big confidence boost given the myriad questions swirling around the legitimacy of Tesla's reported financials.  But the REALLY weird stuff was in between.

The LA Times, which really has had some of the best Tesla coverage, has the best summary I have found so far of the call.  Before I get into some things we learned that helped support my article I wrote the other day, I want to share some of the priceless other highlights of the call.  All from the LAT article:

Tesla faces questions about whether enough new Model 3 sedans can be sold to generate substantial profits.

“The demand for the Model 3 is insanely high. The inhibitor is that people don’t have the money to buy one,” Tesla Chief Executive Elon Musk told analysts on the call.

Yes, I am like an addict on Tesla but I find the company absolutely fascinating.  Books and HBS case studies will be written on this saga some day (a couple are being written right now but seem to be headed for Musk hagiography rather than a real accounting ala business classics like Barbarians at the Gate or Bad Blood).

I still stand by my past thoughts here, where I predicted in advance of results that 3Q2018 was probably going to be Tesla's high water mark, and explained the reasons why.  I won't go into them all.  There are more than one.  But I do want to give an update on one of them, which is the growth and investment story.

First, I want to explain that I have nothing against electric vehicles.  I actually have solar panels on my roof and a deposit down on an EV, though it is months away from being available.  What Tesla bulls don't really understand about the short position on Tesla is that most of us don't hate on the concept -- I respect them for really bootstrapping the mass EV market into existence.  If they were valued in the market at five or even ten billion dollars, you would not hear a peep out of me.  But they are valued (depending on the day, it is a volatile stock) between $55 to $65 billion.

The difference in valuation is entirely due to the charisma and relentless promotion by the 21st century's PT Barnum -- Elon Musk.  I used to get super excited by Musk as well, until two things happened.  One, he committed what I consider outright fraud in bailing out friends and family by getting Tesla to buy out SolarCity when SolarCity was days or weeks from falling apart.  And two, he started talking about things I know about and I realized he was totally full of sh*t.  That is a common reaction from people I read about Musk -- "I found him totally spellbinding until he was discussing something I am an expert in, and I then realized he was a fraud."

Elon Musk spins great technology visions.  Like Popular Mechanics magazine covers from the sixties and seventies (e.g. a flying RV! a mile long blimp will change logging!) he spins exciting visions that geeky males in particular resonate with.  Long time readers will know I identify as one of this tribe -- my most lamented two lost products in the marketplace are Omni Magazine and the Firefly TV series.  So I see his appeal, but I have also seen his BS -- something I think a lot more people have caught on to after his embarrassing Boring Company tunnel reveal.

Anyway, after a couple thousand words of introduction, here is the update:  In my last post linked above, I argued that Tesla is a growth company that is not investing in growth.  Sure, it is seeing growth in current quarters due to investments made over the last decade, but there is little evidence it is actually spending money to do anything new.  It stopped managing itself like a growth company trying to maintain its first-mover advantage.

Tesla has explicitly chosen to pursue a strategy that needs a TON of capital.  Everyone understands, I think, that building a new major automobile franchise takes a ton of investment -- that's why they are not popping up all the time.  But Tesla actually has made choices that increase the capital needed even beyond these huge numbers.  Specifically, they chose not just to manufacture cars, but to also own the sales and service network and to own the fueling network.  Kia was the last major new brand in the US that I can remember, but when it started it relied on 3rd parties to build and operate the dealer/service network and relied on Exxon and Shell to build out and operate the fueling network.  So Tesla has pursued a strategy that they need all the capital of Kia and of the Penske auto group and of Exxon.  Eek.

And for years, they were valiantly trying to pull it off.  They created showrooms in malls and created a new online selling process.  They built some service locations but as has been proven of late, not enough.  They built a supercharger network.  It was a gutsy call that seemed to be paying off.

And then something weird happened.  Somewhere in late 2017 or early 2018 they stopped raising capital and greatly slowed down both R&D and capital investment.

• They slowed expanding the service network at the very time that their installed base of cars was going up exponentially and they were getting bad press for slow service.  Elon Musk promised that Tesla would create its own body shops but nothing has been done on this promise.
• They slowed the Supercharger network expansion at the same time their installed base has dramatically increased and at the same time new competitive networks were begun by major players like Volkswagen.
• They stopped expanding the Model 3 production line at the same time it was clear the current factory could produce only about 5,000 cars per day (with some quality tradeoffs at that) and Musk continued to promise 10,000 a day
• They promised production in China by the end of this year but so far the only investment has been a groundbreaking ceremony in a still muddy field
• They promised huge European sales but only just now got European regulatory approval for sales, dragging their feet for some reason on this approval despite lots of new EV competition starting to hit the European market.
• They pumped up excitement with new product concepts like the semi and the coupe and the pickup truck but there is no evidence they have a place to build them or even have started to tool up.
• Everyone thinks of Tesla as having leadership in battery technology but that is the one area they have actually outsourced, to Panasonic.
• Through all of this, through all these huge needs for capital and despite Tesla's souring stock price and fanboy shareholders begging to throw money at the company, they have not raised any capital for a year.

Since my initial post, we have seen a few new pieces of news

1. Tesla still has not raised capital and in fact faces a $1 billion bond repayment in just over 30 days
2. Tesla admitted that it has not even started working on a refreshed design for the aging Model S and X, despite increasing EV competition coming at this high end from Audi, Porche, and others.  These refreshes should have been started years ago.
3. In fact, Tesla announced it was cutting back on production of the S and X.  Ostensibly this was to focus on the Model 3.  Most skeptics think this is BS, and the real reason is falling demand.  But it doesn't matter -- growth companies with great access to the capital markets don't make these kinds of tradeoffs.  This is further proof that Tesla is no longer managing itself like a growth company.  These cuts are particularly troubling because the S and X are where Tesla gets most of its gross margins -- the Model 3 margins are much worse.
4. Tesla laid off 7% of its work force.  Again, this is not the act of a company that is behind in implementing its growth initiatives, growth initiatives that perhaps 80% of its stock market valuation depends on.

Tesla has always had an execution problem, or more rightly an over-promising problem.  But it was still actually investing and doing stuff, even if it was disorganized and behind in doing so.  Now, however, it is a company valued as an exponential growth company that is no longer managing itself like a growth company.  It has billions of investments that are overdue -- in new products, in product refreshes, in the service network, in a second generation supercharger -- that should have been started 2-3 years ago and for which there isn't any major activity even today.

As a disclosure, Tesla stock is one of the most dangerous in the world to trade, either way.  You really need to understand it before you trade it and no one really understands it.  I have a couple of long-dated put options on Tesla that I consider more of a bar bet than anything else.  I also have a couple of cheap short-dated calls as I usually do in the runup to the quarterly Tesla earnings call.  Musk is great at the last minute stock pump during earnings call week, and the stock often pops only to fall soon afterwards as people dig into the numbers.  But again, these are "investments" that are less than 0.1% of my portfolio.

Postrcript:  When I wrote "Tesla is a growth company that is not investing in growth" I was picturing the Jim Cramer cameo in Ironman -- "That's a weapons company that doesn't make any weapons!"  Of course it took a work of fiction to see Jim Cramer advocate for the short side.  Doubly ironic given Musk sometimes styles himself as the real life Tony Stark.

Readers will know that I have somehow been sucked into the Tesla vortex and spend too much time watching Tesla and Elon Musk's antics.  I tried to explain some of the reasons for this fascination here.  Every time I swear off following Musk, he does some new nutty thing, like his joke of a demonstration the other night of his Boring Company tunnel in LA  (as usual, Musk has come up with another idea that would look cool on the cover of a 1970's Popular Mechanics or Boys Life magazine but fails almost every engineering, physics, and business logic test).

Anyway, I am going to mostly resist writing about Tesla and discuss the strange bias many Americans (really, many Westerners) have against short-selling.  Here is a tweet from a random Tesla supporter that demonstrates what I see every day from Tesla fans:

In TSLA's case, SEC's purpose was the protect shortsellers - which aren't investors.

Bashing the SEC isn't illegal, they have no criminal authority.

— ThemeTeam (@ThemeTeamWP) December 21, 2018

lol no, shorts are not investors. They spread false information for profit and when proven wrong, they move to something else to stay relevant.

— ThemeTeam (@ThemeTeamWP) December 21, 2018

This notion that short sellers are not doing anything legitimate, that they do not deserve legal protections (or else should be banned entirely), and that they prosper only by spreading false information are not just a staple of hard core Musk fanbois, but are actually quite common attitudes.  I saw it just the other night watching the movie The Accountant again (a family favorite in part because a streak of OCD and Asperger's runs through my family).  In this scene, the guy talking is called Brax and he is a gangster and a mercenary, but for a variety of reasons the film-makers need to make him more sympathetic than the average thug.  Watch the justification he gives:

The movie-makers are expecting that the average viewer will discount his thuggery here because he is beating up a short-seller, and we all know those guys are unethical and destructive (by the way, I too would be tempted to short a company that has stuffed its workers' pension fund with its own stock, that is a big red flag to me).

Short selling, in which one is betting the value of an asset will go down in the future, is a perfectly legitimate and valuable way to participate in markets.  For those who are unsure what short selling is, here is how it works.  People who own large blocks of a stock, let's say Exxon-Mobil or XOM, can lend their stock, for a fee, to other people.  They do this as a way to generate extra income for their portfolio, particularly if they intend to hold the stock for the long term.  The people who borrow the stock then immediately sell it.  I know, this seems weird -- your neighbor who lent you his mower might be ticked off if you immediately sold it.  But folks who lend their shares know you are going to sell it.

So I borrow and sell 100 XOM shares for, say, $90.  If the price drops to $70, I can buy the stock back at that price and I make a $2,000 profit.  The risk, though, is that if the price keeps going up, I am going to have to buy back at a higher price and lose money.  If the price goes up too much, the broker is going to issue a margin call and likely force me to pony up more cash or buy back at the unfavorable price to cover my position.  If I had to sell at $110, I would lose $2000.

Note that short selling has a more dangerous risk profile than going long, or buying the stock.  If you buy 100 shares of XOM at $90, the most you can lose is $9,000 -- your losses are capped.  On the other hand your upside is unlimited -- if XOM goes up to $500, you make a fortune.  For short-selling, this is reversed.  The short-seller's gain is limited -- the most they can ever gain is $9,000 if the stock goes to zero.  But their losses are uncapped -- if XOM goes up to $500, they will have lost over $40,000.  And even if the stock shoots up to $500 and eventually falls to zero (as do many bubble companies that get shorted), it may be hard to ride the short position to the end, either due to margin calls or failure of intestinal fortitude.

Short selling makes a ton of economic sense in part because it HAS to improve markets.  First, it increases the liquidity of the market and the number and diversity of participants.  The more subtle reason is because markets and pricing are information discovery tools.  Short selling allows more people with information about a security to participate in this information exchange, which almost by definition improves the market.  As Don Boudreaux wrote years ago:

To ban short-selling of stocks is to short-circuit an important mechanism through which people share their knowledge and expectations with others.  Banning a mechanism that better allows share prices to reflect the expectation that the underlying assets are not worth as much as current market prices suggest does nothing to change the underlying reality.  Such a ban merely distorts knowledge of this reality

I like to think about economics and business issues but I am not an economist.  My layman's way of thinking about short selling was outlined in a post 10 years ago, written in reaction to a temporary ban in short selling during the market turmoil of 2008.

Someone noticed that just before certain stocks crash in value, there is a lot of short-selling.  So the US government has banned short-selling, at least temporarily.  Classic cargo-cult logic.

Boy this sure makes perfect sense in a time when we are concerned about speculative bubbles -- let's ban one of the most important tools that exist for bubbles to be shortened and made less, uh, bubbly.  Here is why (very briefly and non-technically) short-selling takes the edge off speculative excesses.

At the start of the bubble, a particular asset (be it an equity or a commodity like oil) is owned by a mix of people who have different expectations about future price movements.  For whatever reasons, in a bubble, a subset of the market develops rapidly rising expectations about the value of the asset.  They start buying the asset, and the price starts rising.  As the price rises, and these bulls buy in, folks who owned the asset previously and are less bullish about the future will sell to the new buyers.  The very fact of the rising price of the asset from this buying reinforces the bulls' feeling that the sky is the limit for prices, and bulls buy in even more.

Let's fast forward to a point where the price has risen to some stratospheric levels vs. the previous pricing as well as historical norms or ratios.  The ownership base for the asset is now disproportionately made up of those sky-is-the-limit bulls, while everyone who thought these guys were overly optimistic and a bit wonky have sold out. 99.9% of the world now thinks the asset is grossly overvalued.  But how does it come to earth?  After all, the only way the price can drop is if some owners sell, and all the owners are super-bulls who are unlikely to do so.  As a result, the bubble might continue and grow long after most of the world has seen the insanity of it.

Thus, we have short-selling.  Short-selling allows the other 99.9% who are not owners to sell part of the asset anyway, casting their financial vote for the value of the company.  Short-selling shortens bubbles, hastens the reckoning, and in the process generally reduces the wreckage on the back end.

If you want to understand the volatility of a stock like Tesla ($tsla), the issue often is not short-selling but the extremely tiny float -- only a very small percentage of the equity in the company actively trades, while the rest sit in hands of folks who are not going to trade or even lend the stock (e.g. Elon Musk).  With such a tiny float, small changes in sentiment lead to huge price swings, making it a hair-raising investment for both longs and shorts.  This situation would likely be worse without the shorts.

As for the supposed false information spread by shorts, I am sure that happens.  But information gathering by shorts is one of the reasons we should treasure short-selling.  Here is my analogy -- one of the few good things about having Donald Trump as President is that the media actually is doing its job and is skeptical of everything he says and does.  It digs into the truth of his every single statement.  And sometimes what the media comes up with is fake or wrong.  But I would still argue we are better off with this sort of accountability than we were with the media as lapdogs to Obama.  Just look at the problems and potential rights violations at the border.  The media ignored most all of this same activity when it was happening under Obama, but is rightly (finally) highlighting it under Trump.

Trump supporters hate the media, and argue that it was "long" Obama and "short" Trump, but whatever the reason, we are learning things we did not know before and knowledge has value.  Shorts play this same role in the market.  For years everyone fawned over Elon Musk and Tesla.  The dedicated EV magazines were basically house organs of Tesla, a sort of Tesla Pravda.  The longs did not want to see or hear any criticism.  Essentially, no one wanted to be skeptical of the Tesla story except the shorts.   The shorts may turn out to be wrong, but they are finding holes in the Tesla love story and that is valuable.

Postscript:  If you do not invest and want a tiny taste of the hate short-sellers engender, go find the hottest, rowdiest craps table in a Vegas casino and start betting the Don't Come line.

I know I have blogged too much about Tesla of late, and you can be forgiven for just skipping on.  However, I find the situation fascinating -- I have seen splits between bulls and bears on stocks before, but never a situation where there is such a cultural divide between the two groups. What really caused me to write this article is that I have read a number of naive and idealistic people who have written online that they have invested all their money into Tesla.  They love the car, they love Elon Musk, and they are going to trust him with all their money.  EEEEEKKK!  I am going to give my warnings about not being an investment professional in a minute, but I feel more than comfortable even as a regular guy telling you absolutely DO NOT put all your money into a single investment, particularly one you do not control.

So, disclosures:  I am not an investment professional.  I have studied the science of dissecting corporations at Harvard Business School, but I have a less than perfect history of actually trying to make money from this knowledge.   I am short $tsla via put options (a very small percentage of my portfolio), but shorting a stock like this where there is so much passion on the bull side is dangerous.  I and others recognized many of the issues I will discuss in this post over a year ago, but had we been trying to roll puts or sit on a short position all this time it would have gotten very expensive. Making this investment even more risky -- either way, long or short -- is the fact that at this point you are effectively betting on one question: Will Tesla be able to raise new capital in the next 6 months.  This is a question even the experts can't handle and as a result it is probably only safe to dabble in Tesla as a bar bet for most.

BTW, since there is a culture war over Tesla that mirrors the larger culture war in this country, criticisms of Tesla are often interpreted as being based on bad motives and evil intentions.   So I will say that despite having once worked for Exxon, I am not in the pay of the Kochs or other fossil fuel interests, and don't have an axe to grind over electric cars.  I am putting solar on my roof and I have a deposit put down on a Lucid Air.  I have a number of renewables investments in my portfolio, e.g. PEGI.

But I believe the reckoning may be coming soon for Tesla.  If you understand the risks and it is <5% of your portfolio, fine -- take a flyer.  But for any of you that have a lot of money in Tesla and maybe don't have a lot of experience investing or analyzing companies, my advice is get out ASAP.  You have a unique opportunity here that despite a lot of red flags and smoking guns, the stock still trades at a level that will get most folks out of their position cleanly.

The Tesla Passion

Tesla has an incredibly passionate customer base that overlaps a lot with its incredibly passionate investor base.  This passion is based, in part, on:

• The model S which, when it first came out, was years and years ahead of its time.  Every other electric car at the time was a joke -- the model S was a real legitimate luxury sedan one might want even if one did not care about EV's.  The later Model X SUV was also pretty good (though in my opinion not as good).  The current Model 3 is a mixed bag which we will discuss further. But suffice it to say that Tesla earned the right to be called a leader and an innovator in the field
• Elon Musk.  He seems to be passionate about the same things (the environment, hating on oil companies, etc) that his fans are passionate about.  He is involved in amazing, super cool stuff like SpaceX.  He is constantly coming up with new product and service concepts and promising them to his user base.  He responds directly to customer complaints and suggestions and generally promises everyone that they can have their fix or feature really soon.  He has created a mythology that he is Tony Stark incarnate, and many of his fans honestly believe him to be the smartest man on Earth.
• Comparisons to Apple.  Elon Musk and his fans frequently argue that they are reinventing the auto industry as Apple. with the implicit assumption that they will shift historically low auto gross margins to be like Apple's crazy-high gross margins.  How this will happen is left a little vague, but among other things there is a vision of the car as a software platform, where consumers pay recurring fees for a stream of over-the-air features and updates.
• Self-Driving.  Tesla fans are convinced that they are just days away from having full automated self-driving features in their Tesla.  Many paid thousands of dollars on faith for this feature and continue to wait patiently for it to be delivered (which it has not been), even years after paying for it.  It is an article of faith among Tesla fans that Tesla is years ahead of every other self-driving competitor because the smartest guy in the world is running the program.
• The sales process.  The sales process (which is mostly online) seems much friendlier and less intimidating than going in to a dealer, and non-commissioned Tesla employees in their small showrooms seem much more likeable to the average Tesla buyer than the average car salesman.
• Every quarter, promised new products.   Elon Musk is an absolute fountain of new product ideas.  Reading his Twitter feed is like looking through Popular Mechanics covers in the 1970s.  Solar roof tiles! Sending a man to the Moon! Martian colony! Electric Semi!  Electric pickup!  Electric coup!  Self-driving on-demand vehicle service!  A tunnel to Dodger Stadium!  A flamethrower!  The hyperloop!  A $35,000 Model 3!

But beyond all this is the cultural divide between skeptics and passionate Tesla supporters.  Tesla supporters online tend to have little or no financial knowledge or ability to analyze a company's balance sheets and operations, whereas the skeptics tend to be digging through details of balance sheets and pro formas.  One might think this would be a red flag for Tesla supporters, but in fact it just hardens their position.  All of us talking things like cash flow and quick ratios are just dinosaurs, captives of traditional narrow capitalist thinking -- exactly the sort of thing that the brilliant Elon is sweeping away.  We are the ones who are naive at best, or at worst paid short-selling agents of the internal combustion engine lobby.  I have never seen an investing situation like it, and the nearest analog I can come up with is the conflicts between Scientology supporters and skeptics.

So what exactly is the problem with Tesla?  I will name a few of the major ones here, but want to note that much of the credit for the hard investigation and analysis on many of these points go to many folks in the $TSLAQ community, a group often huddled around @teslacharts on Twitter.

Problem #1:  Tesla Has Tried to Disrupt Too Much

I have written about this before, when I said,

One of the hard parts about reinventing an industry is being correct as to what parts to throw out and what parts to keep.  Musk, I think, didn't want to be captive to a lot of traditional auto industry thinking, something anyone who has spent any time at GM would sympathize with.  But it turns out that in addition to all the obsolete assumptions and not-invented-here syndrome and resistance to change and static culture in the industry, there is also a lot of valuable accumulated knowledge about how to build a reliable car efficiently.  In Tesla's attempt to disrupt the industry by throwing out all the former, it may have ignored too much of the latter, and now it is having a really hard time ramping up reliable, quality production.

Ditching the ICE, throwing out assumptions that PEV's had to be silly little econoboxes, and thinking about cars as a software platform are all awesome disruptions and fundamental to the Tesla competitive advantage.  But at the same time Tesla was doing this, it also attempted to throw out 100 years of auto industry learning on manufacturing and selling cars.  On the manufacturing end, Musk promised an "alien dreadnought" with machines that moved so fast humans wouldn't even be allowed in the building.  Tesla has not been able to make this work, and as a result has had to try to relearn old rules of car manufacturing on the fly.  This has hurt both their capacity ramp as well as their product quality.

On the sales end, Tesla wanted to do away with traditional dealers, and the Tesla owners I know loved not having to buy from a car salesman.  But they did not come up with anything to replace the dealer system -- cars still need to be delivered, inventoried for sale, and repaired.  All of these have been huge problems for Tesla in what Musk has called "delivery hell."  Tesla has factory workers moonlighting delivering cars, it has inventory tucked away in all kinds of weird ad hoc lots, and Tesla owners often have to wait months for car repairs, usually because Tesla doesn't build enough spare parts.

Note that Tesla has also saddled itself with building out the entire world fueling network for the car.  ICE car makers can depend on already existing gas station infrastructure.  One could imagine that Tesla might have partnered with someone else to do this -- perhaps a large electric utility or a consortium of other car makers -- but instead has gone it alone building proprietary Supercharger stations across the country.  Time will tell if this makes sense -- it could create a competitive moat protecting it from new competition but it also costs a LOT of capital and leaves them vulnerable to being the odd-man-out of some sort of shared network.

I will end this section by recalling the comparison of Tesla to Apple that so many of its supporters make.  But as far as the iPhone is concerned, Apple is a design and software house.  It does not build the phones, it has a partner do it for them.  It does not write most of the applications, third parties do that.  And (at least in the early days) it did not see through its own stores, it sold through 3rd parties.  An Apple-like Tesla would NOT be trying to build its own manufacturing, service, and fueling capacity -- it would leverage its designs as its unique value-add and seek others to do these other lower-margin, capital-inensive tasks.

Problem #2:  Tesla is Out of Capital (to Operate or Grow) And Seems Unable to Raise More

Tesla has never been profitable and continues to burn through a lot of cash.  It burned through a couple of billion dollars in 2017 and more this year, and right now probably has less than $2 billion on hand with a lot of funding needs, including over a billion dollars of debt that is maturing over the next 6 months.  Tesla may not have the cash even to cover its operating needs over the next 12 months, as Tesla has not been able to prove it can produce the model 3, or any of its vehicles, at a gross margin that will sustain the company's fixed costs.

But forget about operating losses for a moment -- you can go to twitter and argue these to death, and I will address it again below.  But what of Tesla's growth?  Tesla's current factory space is maxed out, so much so that they are building some Model 3's in a big tent.  The Tesla growth story depends on the promised pickup truck and semi truck and coupe, but there is absolutely no place to build them right now -- a place to build them has not even been started and Tesla does not have the capital to create these assembly lines, or likely even to finish the product design.  And even ignoring these, what about the next generation Model  S and X?  In the auto industry, car designs are typically refreshed as a minimum every 4-5 years.  The Model S will be 5-years-old in December of this year.  Where is the new second generation model?  Tesla has enjoyed a 5-year head start on anything like comparable competitive vehicles.  Now, a slew of challengers have been announced and will start appearing in dealerships in 2019 -- Tesla has perhaps 1 more year to buff up its product line before it has real competition.

Besides the car development and production issues, remember we also discussed that Tesla has chosen to build out its own fueling, new car distribution, and car servicing network.  The current distribution issues and servicing complaints make clear that a LOT more capital is going to be needed in these areas.  Capital is needed to inventory parts, to create dedicated storage and delivery centers, and to add more servicing capacity.  Add to this Elon Musk's recent promise to bring body work on Teslas in house and thus create a whole body shop network, and that is a LOT of capital that Tesla does not have.  It is clear to me (though maybe not to Tesla fans) that this capital is not going to come organically through large positive cash flows from operations.

Tesla really needed to raise $5 billion in early 2018.  Its stock was riding high over $350 and its shareholders did not seem to care one bit about dilution.  Why Tesla did not do a capital raise when the money was there and the cost of capital was so low is a total mystery to pretty much everyone.  If nothing else, Elon Musk is absolutely obsessed with "burning the shorts" and the shorts all agree that the one thing that might hurt them in the short term and drag out their returns for years is a large capital raise.  So why not?

One prominent theory among short-sellers and Tesla skeptics is that there is some sort of grand secret inside Tesla -- an investigation or a bad set of numbers or even some kind of accounting fraud -- that prevents Tesla from making the disclosures necessary to go to the capital markets.   I am not sure this makes sense -- what secret could be so bad and still stay secret for so long?   The fact that Tesla seems to hemorrhage senior accounting officers, finance VPs, and controllers just adds to the mystery.  Whatever this mystery barrier to capital raises has been, it has only gotten worse with Tesla's recent SEC investigations and on-again-off-again settlements.  No matter what, the result is that Tesla is starved of capital and apparently cannot easily get more.

If you buy or sell Tesla, this is essentially the question you are betting on -- Can Tesla raise capital?  If they can't in the next 6 months, they are likely headed for bankruptcy or restructuring (but either way wiping out most of the equity holders).  On the other hand, if they were to announce a multi-billion dollar capital raise tomorrow, the stock would rocket back in to the high 300's and all the shorts would be at least temporarily burned (though Tesla would still have long-term structural challenges).  This is why it is inappropriate to have much more than a small piece of your portfolio either long or short Tesla -- you are effectively betting on whether this capital raise will happen and even the experts can't fathom it.  I think it won't happen for the simple fact that if it could have happened, it should have already occurred, but I could be wrong.

Problem #3:  Tesla is an Operational Mess and Not Good at Fulfilling Promises

Elon Musk makes a lot of promises, promises that get a lot of folks excited, but very few of these promises are ever met.  In the long list of promises I listed right up at the top, very few if any have been fulfilled.  For example, Tesla still is not anywhere near the production rates for the Model 3 that Musk promised it would reach over a year ago, a promise so clearly broken that Tesla is being sued over it.  Musk claimed as many as a half-million pre-orders for the Model 3 mainly on Musk's promise to sell it for net $27,500  ($35,000 less the $7,500 federal tax subsidy).  Now the $35,000 version is not even on the manufacturing plan (Tesla still can't figure out how to make money on it) and it certainly will never be produced before Tesla starts losing the $7500 subsidy after December.

For years Musk has pulled new product rabbits out of his hat every quarter, just when he needed them to complete financing or an acquisition.  After the the stock pops up in response, little is ever heard of the suggested product again.  The battery swap technology that got California to give Musk bigger subsidies has completely disappeared from the radar screen.  Musk demonstrated what he said was a completed solar roof tile technology just in time to sell Tesla shareholders on the idea of bailing out SolarCity, but again the technology has never materialized and SolarCity has essentially been shutting down, with fewer new installations each quarter.   The same was true of the Semi truck, released to great fanfare but totally MIA today.  And beyond these promises are crazy, clearly inaccurate promises from Musk that they are taking all body shop work in house immediately or that they are producing their own auto carriers to alleviate a supposed auto carrier shortage.  And even this does not include the small promises he has made almost every day to users to add this or that new feature.  It is almost as if Musk has a psychological need never to admit that there is a problem for which he has not already implemented a solution.

Worse, the products Tesla is making are not fulfilling Tesla's early promise.  Specifically, Tesla fan boards have been full of stories about delivery defects in new Model 3's, including parts that fall off and body panels painted the wrong color.  Leaks from inside the factory have hinted at first-pass yields on the model 3 that are close to the worst in the entire auto industry.  To try to keep investors happy, Tesla has promised that they would produce 5000, and later 6000 model 3's a week, but rather than achieve sustainable production at these levels the factory has engineered a couple of crazy push weeks where production is juiced to these levels, and then falls back to lower rates.  This is probably one reason for the quality problems, and certainly is not a recipe for reducing production costs.

Problem #4: Q32018 May be Tesla's High Water Mark

Which brings us to the 3rd quarter results, which should be announced in just a few weeks.  Musk has been vociferously promising for months that Q3 and Q4 would be GAAP profitable and cash flow positive.  He went so far as calling out the Economist Magazine for having the temerity to suggest that this did not sound realistic.

Perhaps as a result of this very public commitment, Tesla has very clearly pulled out all the stops to really juice the third quarter.  For example:

• It carried over a lot of inventory from Q2 to be sold in Q3
• It has mined its order book to find all the folks who have ordered the most profitable cars.  It abandoned the promised first-come-first-served manufacture-to-demand approach to focus on batch producing cars for those who ordered the highest margin versions.
• It has mined two years of orders and sold them all in one quarter
• It has reportedly done a sale and leaseback of all its demonstration and loaner fleet
• It has reportedly taken full payment from multiple people for the same car, delivering it to one person and holding the money from the other for a 4Q delivery.
• It has stretched out the time it takes to repay deposits for cancelled orders to 45 days
• It has stretched its payment to vendors, resulting in a number of vendor complaints.  As a result its net working capital has gotten more and more negative.
• It has had special end-of-quarter sales of inventory
• It has used expensive promotions (e.g. free Supercharging for life) that it promised earlier not to use again in order to move inventory at the end of quarter
• It has switched to batch production from produce to order in the factory, presumably to cut costs and increase throughput but having the effect of creating inventory for which there is no current buyer.
• Once it was too late for manufactured cars to get sold in the quarter, it cut way back on production in the last days to conserve cash.
• Tesla has some undisclosed number of government ZEV credits it can sell, which would lead to a one-time increase in profits and cash flow.  Tesla takes advantage of a loophole in GAAP accounting to leave these off their balance sheet, presumably so they can act as Musk's personal burn-the-shorts slush fund.

It is not clear if this will result in a small profit or positive cash flow.  The problem is that whatever Q3 results are, they will be almost impossible to duplicate in Q4.  Tesla will likely talk about what a growth trajectory Q3 represents over previous quarters, and they will be right, but what will be missing from the story is how nothing will be left in the tank for Q4.

The following is essentially speculation, because Tesla refuses to answer any questions about their order backlog.  In fact, Musk famously blew off an analyst in a previous conference call who tried to inquire about the order backlog.  But there are good reasons to think that the backlog of profitable customer advance orders and deposits is tapped out, that Tesla in Q3 has serviced everyone in the backlog who wanted a car that could be produced at a reasonable gross margin and everyone else in the backlog are folks who ordered cars, particularly the $35,000 Model 3, that Tesla has no intention of building any time soon because they would lose their *ss doing so.  In this context, Q3 is not an organic quarter in the midst of a growth trend but a manufactured quarter where over 2 years of pre-orders were tapped in one three month period, leaving nothing in the tank for the future.

The evidence for flattening demand for Tesla is pretty compelling.  Model S and X sales volume has basically been flat for over a year.  And as for Model 3, the unsold inventory tucked away in random locations combined with the desperation fire sales at the end of Q3 point to a saturation of demand.

Note that a flattening of demand has a double whammy for Tesla.  First, it means that their stock valuation will likely crash.   Tesla's valuation at huge multiples of revenue (there is no profit) only makes sense for a rapid growth company.  If the rapid growth tails off, the valuation will come to Earth.

And this is not even the biggest problem.  Let's take a step back.  In the old days, say in the 1980's, growth was a consumer of cash.  This is because manufacturing and inventory cycles were long.  Growth meant investing in more parts and production now, only to get higher revenues later -- working capital skyrocketed with growth and could nearly bankrupt otherwise healthy growing companies.

Today, however, supply and manufacturing chains are much shorter.  Products can be produced and sent to customers before the vendors are even paid.  Dell computer was an innovator on this, getting paid by customers for a PC before Dell itself had paid for any of the parts.  Combine this with Tesla's innovation of having customers put down deposits on their cars months or years before the sale, and this means that growth actually creates cash for Tesla as working capital becomes more negative.

I have the same thing happen in my seasonal business.  Through the spring, as I hire people and visitation to our campgrounds increases into the summer, we get big increases in revenue immediately while we don't have to pay new hire salaries for a couple of weeks or expenses like trash for months.  Growth generates cash because we get the revenue before we pay the expenses.  But the whole thing reverses itself at the end of season, as revenues fall and all the bills come due.  This negative cash flow effect as revenue growth reverses at the end of the operating season almost bankrupted me the first couple of years until I learned to plan for it.

In the same way Tesla has been getting positive cash flow (via negative working capital) from growth, but this will reverse the moment that growth slows.  When their growth inevitably slows in the fourth quarter, no matter how well they claim to have performed in the third quarter, Tesla is going to see a huge cash crunch.   I am not sure they will have the cash to cover it, and smarter people than I are betting on a Tesla bankruptcy or restructuring in the next 2-3 months.  Any such event will largely wipe out equity holders.   Which is why I am advising you to keep away.  Elon Musk and Tesla may have some double-secret plan to avoid this cash crunch, but are you willing to bet your savings on it?

Problem #5:  Elon Musk is NOT the Smartest Man on Earth

The ultimate answer to all these concerns about Tesla by Tesla fanboys is that they have confidence in Elon.  I see people write on boards, dead seriously, that Elon is the smartest person in the world.  One wrote two days ago that they thought he was the smartest guy in history.  They have confidence that Elon will make things work out, and that Elon will always be able to attract new capital because everyone in the world feels the same love for Elon that they do.

Here is the problem:  Elon Musk is not the smartest guy in the world.  He is clearly a genius at marketing and brand building.  He has a creative mind -- I have said before he would have been fabulous at coming up with each issue's cover story for Popular Mechanics.  A mile-long freight blimp!  Trains that run in underground vacuum tubes!  A colony on Mars!  But he suffers, I think, from the same lack of self-awareness many people develop when they are expert or successful in one thing -- they assume they will automatically be equally as brilliant and successful in other things.  Musk creates fanciful ideas that are exciting and might work technically, but will never ever pencil out as profitable business (e.g. Boring company, Hyperloop). Musk is not good at managing operations or manufacturing.  He does not seem like a very good planner, which should be a must in a business with long lead times and billions in capex.  He has brought too much of the "fake it before you make it" culture from the web world, where the stakes attached to unsuccessfully faking it are so much lower than they are in, say, the car business.  This natural tendency to overestimate one's abilities is just made worse by all the fan attention that constantly tells him he is the real Tony Stark and the Smartest Man on Earth.

SpaceX works pretty well because someone who is not-Musk and actually knows that business runs the operations and designs the product.  Even in Tesla, the Model S was designed by someone else, as much as Musk would like to claim credit.  I have said for over a year that Tesla needs to find the right role for Musk and it is NOT CEO and COO and CTO and chief Tweeting Officer all in one.   Tesla needs Musk at this point as their face to the public.  He would be a good chairman and could help lead the company's product road map.  He is great at communicating exciting things to the public -- within limits.

The "within limits" proviso in the last line is based on what is surely Musk's worst flaw -- he can be a petulant, impulsive, unreliable child on Twitter.  I won't go into all the stories, most of them made the national news, but  he tried to insert himself into the Thai cave rescue story and when his contribution was not useful, called out one of the rescuers as a pedophile.  He frequently is obsessed with short-sellers and taunts them with promises to burn them.  He reacts poorly to criticism and bans a lot of critics on Twitter.  And, most disastrously, he tweeted that he had funding secured for a $420 buyout of Tesla that caused the stock to shoot up, only to fall back to Earth when it was revealed that no such offer existed.  This latter event was a clear violation of SEC rules, and after an SEC investigation Musk and Tesla settled with the SEC.  But even that was not the end, as Musk then repudiated the settlement, and then two days later signed a new more onerous settlement, and then a few days after that mocked the SEC over twitter in a clear violation of the terms of the settlement he just signed.  Which is where we sit today, waiting to see how the SEC responds to this latest outburst and with rumors swirling that other SEC and justice department investigations may be in progress at Tesla.

Which leads to the question -- is Musk just immature on Twitter, or is he actually corrupt ala Elizabeth Holmes at Theranos or the smartest guys in the room at Enron?  People might respond that Musk is a brilliant, visionary guy -- he can't be corrupt!  But my wife who has to have her blood tested a lot loved Elizabeth Holmes and her vision.  I personally worked with Jeff Skilling briefly at McKinsey before he went to Enron and he was both visionary and a real genius.  The way he introduces new products right when he needs an external boost, and then drops them, looks a lot like a stock-pumping operation.  And I personally think the Tesla bailout of SolarCity was completely corrupt -- it benefitted Musk and his friends and family at SolarCity and did less than zero for Tesla shareholders.

*     *     *

That is the situation as I understand it.  If you still want to make a big bet on Tesla, one way or other, hopefully you are a bit better informed of the risks.  Trade carefully, as the saying goes.  Or do as I do, and just watch the show because it is enthralling.

As of this moment, Canadian tulip bulb marijuana company Tilray is trading at $146 a share for a total market capitalization of $11.2 Billion.  This is a company that had $10 million in revenues last quarter.   It is trading at a 420x multiple of last year's revenues.  It is up 20% today alone.  The race to own Canadian marijuana stocks in advance of the January 1, 2019 legalization in Canada is simply insane.  I would have attributed this to millenial dumb money leaving Tesla and looking for a new home, but a couple of weeks ago, American alcoholic beverage company Constellation Brands paid $4 billion for just a piece of another Canadian weed company.

Investments at this sort of valuation before the market even is opened are speculative in the extreme.  People will use the argument that "wouldn't you have wanted to be in on the ground floor of Coke or Pepsi or Phillip Morris or Anheuser Bush?"  A few responses:

1. Buying in at an $11 billion valuation is not really the "ground floor".  $11.2 billion is a higher market cap than Whirlpool or Hyatt or Alcoa.
2. The beer and cigarette and soft drink industries all started with hundreds, even thousands of competitors.  When RJ Reynolds started his tobacco company, there were 15 other tobacco companies in Winston-Salem alone.  Without your current hindsight, you would have been hard-pressed in the early stages of those industries to pick the winner.
3. This goes without saying, but we have no idea of the future size of the marijuana market, and even without the risk of trying to predict consumer behavior it is really hard to predict regulatory behavior
4. Usually only one part of the value chain of a new industry really makes the profits.  We have no idea where that will be in the marijuana business.  In beer and tobacco, the big profits are not with the growers of tobacco and hops, for example.
5. Early pioneers in an industry are often not the survivors.  Your computer today, is it a Tandy?  Kaypro?  Commodore?  IBM and Compaq don't even make PC's any more.  Apple does but only because it reinvented itself as a phone maker.  And how about those cell phone pioneers?  Is your phone a Nokia?  Motorolla?  Blackberry?

December $145 put options on Tilray are trading around $72 dollars, which essentially means that there are folks betting that the company will lose half its value in the next 90 days.  I can't remember ever seeing anything that extreme.

Update:  Well, a day later it is at over $200 and a $20 billion valuation.  Incredible.

You may not see much Tesla coverage here for a while, despite a lot of breaking news.  Here is why:

The dominoes are all lined up, and that was an interesting story (the dominoes include:  Tesla's poor management of a good product, its lack of adult supervision, its repeated failure to meet targets, its utter contempt for being held accountable to targets, its paranoid worldview, its past near-corrupt actions like the insider SolarCity purchase, Musk's irrational hatred of shorts, its running out of cash without any plan for a capital raise, the fanboys who would eat any dog food Musk served up, etc.)

The first domino has been tipped over (Musk's outright lie that he had funding secured for a $420 buyout when he had not even talked to bankers or his board yet, just to tweak the shorts for a few hours in one day).

Now, I am not sure that I find further falling dominoes that interesting -- after all, it is just inevitable physics at this point.

Note:  The crash is likely to be much slower than at Enron.  Once confidence failed in Enron, the crash came almost at once because Enron was like a large bank that was investing long and borrowing short.  Once the short-term borrowing window was closed for them, it was over.   Tesla can likely make it 6 months before they start scraping bottom and/or their debt covenants.

Update:  For the Tesla fanboys who seem super-excited about the loss of liquidity moving to a private company, here is what being a minor shareholder in a private company is like:

Three of Tinder's co-founders and several other current and former senior executives are suing the dating company's parent organizations, Match Group and IAC. According to a complaint published online, the lawsuit seeks billions of dollars in damages for allegedly manipulating financial information in order to reduce Tinder's valuation and illegally take away employees' stock options.

The complaint explains that Tinder was supposed to be valued in 2017, 2018, 2020 and 2021; On those days, employees should have been able to exercise their stock options. Instead, the lawsuit alleges that parent company IAC/Match Group inaccurately lowballed Tinder's valuation in July 2017 at $3 billion, the same as it did two years ago despite the dating app's substantial growth. Then, the parent company secretly merged Tinder into Match Group, which meant employees earned far less in stock options. Then, IAC threatened to terminate anyone who revealed how much the company was actually worth, the lawsuit claims.

I had dinner last night with my old college roommate Brink Lindsey and he even sort of rolled his eyes about my recent Tesla obsession, so I really really will try to make this the last post for a while.  However, I have to count coup on a few accurate predictions I made last week here and here.

First, I said, in reference to how Musk can bail himself out of his "funding secured" tweet when it has become clear this is not the case:

So what can Musk do?  Well, the first defense might be to release a statement like "when I said funding secured, I was referring to recent conversations with ______ [fill in blank, maybe with Saudis or the Chinese, call them X] and they told me that if we ever were looking for funds they would have my back."  This is probably the best he could do, and Tesla would try to chalk it up to naivete of Mr. Musk to accept barroom conversation as a firm commitment.  Naivite, but not fraud.   I don't have any experience with the Feds on this kind of thing but my guess is that the SEC would expect that the CEO of a $50 billion public company should know the rules and legally wasn't allowed to be naive, but who knows, the defense worked for Hillary Clinton with her email servers.

Today Musk writes:

Recently, after the Saudi fund bought almost 5% of Tesla stock through the public markets, they reached out to ask for another meeting. That meeting took place on July 31st. During the meeting, the Managing Director of the fund expressed regret that I had not moved forward previously on a going private transaction with them, and he strongly expressed his support for funding a going private transaction for Tesla at this time. I understood from him that no other decision makers were needed and that they were eager to proceed....

I left the July 31st meeting with no question that a deal with the Saudi sovereign fund could be closed, and that it was just a matter of getting the process moving. This is why I referred to “funding secured” in the August 7th announcement.

Of course the Feds probably expect "funding secured" to mean a signed term sheet (which does not exist) accompanied by an 8-K (which STILL has not been issued).  I then said in my prediction:

But this defense is MUCH MUCH better if, in the next day or so, Tesla can announce a deal with X on paper with signatures.  Then Musk can use the same defense as above but it has much more weight because he can say, see, they promised funding and I believed them when they said they had my back and here they have delivered.

And today we learn:

But was the funding really secured? Apparently not, because in the very next paragraph Musk writes that "following the August 7th announcement, I have continued to communicate with the Managing Director of the Saudi fund. He has expressed support for proceeding subject to financial and other due diligence and their internal review process for obtaining approvals. He has also asked for additional details on how the company would be taken private, including any required percentages and any regulatory requirements."

Hmmm.  So basically Musk had a chat with the Saudis that did not include any due diligence, any percentages, or anything about the structure of the transaction and nothing has been submitted formally to the Saudis for the required review and approval.  The Feds would never accept this BS from an unpopular CEO like, say, Jeff Skilling.  It remains to be seen whether they will really go after cultural icon Musk.

Finally, I predicted the odd and relatively unprecedented transaction that Musk likely envisioned:

Here is what I think Musk wants -- he wants an LBO without any actual change in ownership. Basically he wants to create Tesla New, which will be private and not trade on the markets. He is hoping that all his current fanboy shareholders will exchange a share of Tesla for a share of Tesla New. Musk has already said he will do this with his 20%. In the extreme case, if every current shareholder wants in on the new private company, then no capital at all is needed for the LBO. Musk might admit that perhaps a billion or two are needed to buy out the few recalcitrants at $420, and then all the Tesla fanboys can enjoy short-seller-free illiquidity

There was no way that Musk could expect to raise $70-$80 billion ($420 times the float) or to run an already cash-starved business with that much debt.  The only way to imagine this is if the buyout was only of a small percentage of owners.  And sure enough, here is Musk this morning:

Therefore, reports that more than $70B would be needed to take Tesla private dramatically overstate the actual capital raise needed. The $420 buyout price would only be used for Tesla shareholders who do not remain with our company if it is private. My best estimate right now is that approximately two-thirds of shares owned by all current investors would roll over into a private Tesla.

I won't comment on whether this is possible because I don't know enough about security laws.  I have been told that the SEC would likely frown on a private company with no public disclosures that has thousands or even millions of individual shareholders, but again, I don't know.

I find it amazing that anyone would want to stay in on this basis, but like Musk, the Tesla fan-boys seem to care more about burning the shorts than the quality of their own long investment in Tesla.  How can moving your small (percentage-wise) investment in Tesla from being exchange-traded to being locked up in a private company possibly be an improvement?  Today your investment has total liquidity (you can sell any time), it has massive 3rd party scrutiny and accountability, and it has real-time price discovery.  You would lose all of that in a private company.  You can only sell when Musk lets you sell and at the price he chooses to give you based on whatever company information he chooses to release.  Choosing the private option as a minority shareholder is like saying that you would rather hold non-refundable airline tickets than fully refundable ones.

Postscript:  I am new to the world of short-selling fights, as I am not really an active investor and just got sucked into watching Tesla because I found it interesting.  But wow, the tribalism of politics sure has leaked into the investment world!  In tribal politics, we see people more motivated by hatred of the other tribe than by making progress on their own tribe's goals.  This same kind of "reasoning" seems to dominate a lot of the Tesla long-short battle.

Update:  Here is a new prediction.  For a while Elon Musk has claimed he will not have to raise capital this year.  Everyone basically looks at his numbers and thinks he is nuts.  What's more, given his $50 billion equity valuation currently, he SHOULD be raising capital now while his stock is high and thus his cost of capital is low.

But one way to look at this is if he raises $20 billion in equity to buy out the 1/3 he thinks will want the cash rather than the new stock, he could easily just make that $22 billion so the company has an extra $2 billion in operating cash and thus raise capital this year without it looking like he violated his promise not to raise capital.

So the last couple of days I was bored and I logged into Twitter for the first time in a while and spent a few hours trying to convince myself that if I really wanted to, I could build a presence on Twitter.   Increased my follower count from about 1000 to about 1300 and got some notice and retweets.  And pretty much zero satisfaction, so I think we are going to declare that experiment over for a while.  But, this time, unlike the last effort, I managed to pretty much remain a nice guy and not become a hateful troll, so that is a step forward.

Anyway, weirdly, I managed in the process to create my single most -- by far -- liked and retweeted post, and it is really random.  It was just a toss-off reply to @popehat when he asked rhetorically if dentists all hire awful lawyers.  So I wrote this (which is an entirely true experience)

When I was at Harvard B-School, in an investment analysis class, if the investment sucked the professor would say, "who do we sell this to?" and the class would scream "doctors!" If the investment really, really sucked, we all screamed "dentists!" https://t.co/20TwcgXgga

— Coyoteblog (@Coyoteblog) August 8, 2018

I do not have any insider knowledge, so this is pure speculation, but I have worked in a lot of organizations that did insane things to try to reach milestones or goals, and so I think it is educated speculation.

A lot of Tesla's market valuation comes from the prospects of getting a lot of volume with their mid-priced (sort of) Model 3.  They need to get production rates up both to reduce costs and to try to get ahead of a huge oncoming rush of competitors entering the BEV space.  Last year, they promised to have Model 3 production at 5000 a week by the first of this year, a goal they missed by a mile.  So now they have set the expectation that they will be at 5,000 a week production by the end of the second quarter, which is basically this week.

One of the weird things about Tesla is the difficulty in getting good information about its operations, particularly since it is a public company.  So many investors, for example, were trying to figure out Model 3 production numbers that an entire cottage industry of VIN analytics and delivery reporting has arisen.   But the basic story is that they are not there yet and that's not going to change by the end of the week.

But that does not mean they won't be trying to achieve something that looks like 5,000.  In the past Tesla has resorted to the "run-rate" claim, that their run rate for a day or an hour was at such and such much higher number.  So that is, I think, what is going to happen this week.  Parts and subassemblies are likely being stored up so that in a great burst 714 can be completed in one day or if not that, 30 or so can be completed in an hour so that the company can claim a 5,000 unit weekly run rate was achieved.  This is obviously BS -- any bottlenecked process can usually be juiced for a short period of time (examples:  Transcontinental Railroad track laying record, Liberty ship build time record) -- but I predict we will see it.  I also wouldn't be surprised if you found the numbers for last week were actually below trend due to Tesla hoarding sub-assemblies and parts for huge one-off production push this week.

As an aside, we are coming up to June 30, which for taxpayers can be considered Tesla subsidy day.   I have written about this before, but if Tesla can manage its deliveries down a bit in the second quarter, it can extend the taxpayer subsidy of its vehicles another 3 months (the subsidy starts winding down after the 200,000th electric vehicle sold in the US and Telsa is right about there, so much so that rumors are it is sending all its output to Canada this week so it doesn't put them over the US number.  Bloomberg estimates that pushing the 200,000th sale from June 30 to July 1 will cost US taxpayers hundreds of millions of dollars:

In my previous post I wrote about Tesla's attempt to prolong the $7,500 U.S. incentive for electric cars by pushing sales into the next quarter. A reader on Twitter who goes by the handle @Smack_Check did the math on how much such an effort would be worth to Tesla's customers: $366 million.

That's the value of additional credits available if Tesla waits just one day (July 1, instead of June 30) to record its 200,000th sale in the U.S. Here are @Smack_Check's fairly conservative assumptions:

Tesla will produce an average of 5,000 cars a week in the third quarter, all models combined (that means about 3,000 Model 3s/week, on average).
Each quarter after that, total weekly production will rise by 1,000.
U.S. sales will account for half of all Tesla sales worldwide during the subsidy period.

Disclosure:  I am short Tesla via the ownership of one (1) put option which in my mind constitutes more of a bar bet than an investment.  Shorting fan-boy stocks is risky, as is shorting companies the CA legislature is probably scheming right now to bail out somehow with their taxpayer money.  If it were not for these two problems I would be all-in on the short like James Bond at the end of Casino Royale holding a straight flush.   The odds that Tesla will really be worth $60 billion * (1+i)^10 in ten years is pretty much zero.  Also, it's amazing how many of Elizabeth Holme's behaviors at Theranos as documented in Bad Blood one can observe in Musk.

Update:   Fixed Tesla current market value, which is closer to $60 billion today.

This morning on my short drive to work I heard a commercial that reminded me of the glory days of 2005.  First, it was a commercial for a home equity loan, a pitch that largely disappeared for a decade or so.  Second, though, the pitch said that you could take the money and put in in the stock market or -- I am not kidding on this, I think I got it word for word -- "buy the dip in the Bitcoin market".    There you have it:  Borrow against the theoretical unrealized price gain in your home and use it to market-time Bitcoin prices.  Take your paper gain in one bubble and apply it to a bigger bubble.  Nothing could go wrong there.